If you are among the many active investors and stock traders today who have a keen interest in breakout trading, you will want to know about a stock options trading strategy perfect for breakouts, known as a call backspread. This bullish trading strategy offers the advantage of limited potential losses and unlimited potential profit. There is even some potential downside profit. In this article, we will look at an actual example of a breakout and show how a backspread can be used to gain profits with limited risk.
Tutorial: Detecting Market Strength
The Breakout Stock
The stock presented below is Inamed Aesthetics (IMDC), which develops and manufactures such products as implants for aesthetic augmentation and reconstructive surgery, as well as dermal products to treat facial wrinkles. As you can see in Figure 1, the stock has a cup and handle technical chart formation, with a breakout occurring on Aug. 10. If you believe the stock has the potential to resume its rally, then you might try applying a backspread. The strategy may seem complicated, but if you are an experienced trader, you will find it is actually fairly simple.
As Figure 1 shows, IMDC recently broke out of a long base and is now consolidating the move out of its cup and handle formation. (To learn more about the cup and handle pattern and other patterns and indicators, see our Technical Analysis tutorial.)
Assuming you maintain a bullish outlook on IMDC, you could apply a call backspread, which benefits from a rise in the stock price, beyond a certain point. If you believe this stock, which is fundamentally and technically strong, is headed still higher, a call backspread could produce a windfall profit.
Applying the Backspread
To apply the trade, you would simply buy Oct. 2 (out-of-the-money) 75 calls, selling for $2.80 a piece, and sell Oct. 1, (in-the-money) 70 calls, which would fetch $5.90 (the bid price). The details of this trade are presented in Figure 2.
|+2 Oct. 75 Calls||2.80 (Ask)||-$560||--|
|-1 Oct. 70 Calls||5.90 (Bid)||+$590||+$30|
|Figure 2 – IMDC October Call Backspread|
As you can see, the ratio of two long calls to one short call actually creates a small credit of $30, this is not counting commissions, which would likely be about $5 at a good discount broker. If the stock experiences a large decline, you will keep this $30 credit. However, if this trade was created at a net debit and the stock substantially dropped in price, the amount paid to set up the spread would be the maximum amount of loss that the trader would incur.
As you can see in Figure 3, this October call backspread has unlimited profit potential if IMDC resumes its move higher, with upside breakeven at 79.7, 8.4% higher from the entry point. While this may seem like a lot, keep in mind that 75% of these types of breakouts will run 5% or more, with 55% running 20% or higher, according to data for the past several years. When they fail, the majority tend to fail big, a point we will turn to below.
Should the move fail and the stock not rally significantly, the maximum loss potential is $470, which would occur if the price stalled at expiration (the third Friday of October, or Oct. 21), 60 days after entering this position, and settled at 75 (the long call option strikes). However, if the failure is acute, which is common with most of these types of breakouts, the stock will fall well below the breakout point, down to where there is potential for a small gain. In this case, the stock would need to fall below 70.3, from its current level of 73.5, in order to experience a small profit.
In an ideal situation, when applying the backspread, you would want the stock to move higher and to do so quickly, because the trade does suffer from time value decay, even though it is a net credit spread. One way to manage this trade dimension of time value decay, if you don't want to wait until expiration to see results, is simply to exit if and when a maximum money stop-loss dollar amount is reached. Meanwhile, if the move higher occurs, it is possible to roll the legs of this trade higher to lock in profits. (For more on this topic, see The Importance of Time Value In Options Trading.)
The Bottom Line
This real-life example should provide you with some fresh ideas about trading breakout stocks with a limited-risk stock options strategy. The call backspread setup presented here has much less risk and uses much less capital than simply buying the underlying. The margin cost of this trade at a good options broker should be no more than the maximum loss potential of $470. Compare this with owning the equivalent 100 shares of this stock, which would tie up $7,450! Furthermore, if you were to apply the stop-loss percentage of 8% that breakout traders typically use with cup and handle formations, you would lose $588; compare that to the $470 you'll lose if maximum losses occur on the backspread.
Finally, keep in mind that if the failure is bad enough, that is, if the price declines are big, you might even make a small profit, rather than a big loss. (For an overview of what options are and how they work, see the Options Basics tutorial.)